How A Regulation Helped Ease Way For Stock Market's 'Flash Boys'

High-frequency trading has drastically altered the stock markets — and not always for the better, as the book Flash Boys makes clear. The roots of this kind of trading lie in a regulation passed to encourage the spread of electronic exchanges. Now, some critics say it's time to decide whether new rules are in order.

And I'm Audie Cornish. In recent years, high speed computers have drastically altered the way the stock market operates. What's called high frequency trading has been getting renewed attention thanks to "Flash Boys," the latest book from Michael Lewis. In that book, he argues the changes have created a lot of new problems.

We're going to take a look now at why. The surge in high frequency trading has its roots in regulation passed in 2005. NPR's Jim Zarroli says the changes were supposed to benefit investors, but they've had some unintended consequences.

JIM ZARROLI, BYLINE: The changes approved by the Securities and Exchange Commission nine years ago were aimed at promoting competition in the stock market and in the process dragging it into the electronic age. Here was SEC commissioner Harvey Goldschmid.

HARVEY GOLDSCHMID: The packet of proposals before us today can accurately be described as the most significant modernization of the national market system since the original rules were adopted by this commission in 1975.

ZARROLI: At the time, stock trading was still dominated by the NYSC and NASDAQ, but new electronic exchanges were starting up. Those new exchanges could often give investors a better price. The new SEC regulations said that when a stock exchange got an order, it had to find the best possible price for the investor. Chester Spatt is a former SEC economist now at Carnegie Melon University.

CHESTER SPATT: You have to basically go around and look and see is anybody bettering the price that I'm prepared to offer. And only once I do that can I then execute the rest of the customer's order.

ZARROLI: Under the new electronic trading systems, orders could be processed in a flash, and Spatt says that put a big premium on speed.

SPATT: You had to basically be certified as fast if you were going to have access to all of this and if you were going to be a serious player, you had to be fast. And this really forced the NYSC to change the way it did business.

ZARROLI: Soon new exchanges were sprouting up everywhere. Today, when an investor places an order, it may get rooted through dozens of exchanges, trading platforms and private markets called dark pools and over time, traders have been able to exploit the links among the exchanges. They've figured out ways to peer into the other exchanges, see what trades are coming up and then take advantage of them using ultra fast computer networks.

Eric Hunsader is the founder of Nanex.

ERIC HUNSADER: And that's where the speed advantages come into play because the high frequency traders are able to detect part of that order, execute it on one exchange and before that smart order router can get the bulk to the rest of those orders to the other exchanges, they've already adjust their prices.

ZARROLI: Critics say these changes have ended up costing investors money and increasing volatility in the market. High frequency trading firms dispute that, but even within the industry, there's a sense it might be time to pause for a breath. Peter Nabicht is with the Modern Markets Initiative, an industry group.

PETER NABICHT: We've got the data. I think we need to take a very good look at what's worked and what hasn't.

ZARROLI: In fact, the SEC has begun a review of stock market structure to better understand the changes taking place. It's looking into something called regulation NMS, the 40-year-old set of rules that government market structure. Eric Hunsader, a long-time critic of high frequency trading, says the SEC doesn't need new regulations. It just needs to better enforce the ones it has.

HUNSADER: If we had followed that, things would be a lot better than they are today. We haven't really had a chance to see reg NMS in action because the regulators not doing their job.

ZARROLI: But the changes that have swept through the markets in the past decade are incredibly complex and difficult to comprehend and there's a growing sense that it may be time to take a new look at the forces unleashed by the SEC nine years ago. Jim Zarroli, NPR News, New York.

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